Protectionist Trade Policies:A Survey of Theory, Evidence and Rationale

Cletus C. Coughlin, K. Alec Chrystal and Geoffrey E. Wood

Protectionist pressures have been mounting worldwide during the 1980s. These pressures

are due to various economic problems including the large and persistent balance of trade

deficits in the United States; the hard times experienced by several industries; and the

slow growth of many foreign countries.1 Proponents of protectionist trade policies argue

that international trade has contributed substantially to these problems and that

protectionist trade policies will lead to improved results. Professional economists in the

United States, however, generally agree that trade restrictions such as tariffs and quotas

substantially reduce a nation's economic well-being.2

This article surveys the theory, evidence and rationale concerning protectionist trade

policies. The first section illustrates the gains from free trade using the concept of

comparative advantage. Recent developments in international trade theory that emphasize

other reasons for gains from trade are also reviewed. The theoretical discussion is

followed by an examination of recent empirical studies that demonstrate the large costs of

protectionist trade policies. Then, the rationale for restricting trade is presented. The

concluding section summarizes the paper's main arguments.

THE GAINS FROM FREE TRADE

The most famous demonstration of the gains from trade appeared in 1817 in David

Ricardo's Principles of Political Economy and Taxation. We use his example involving

trade between England and Portugal to demonstrate how both countries can gain from

trade. The two countries produce the same two goods, wine and cloth, and the only

production costs are labor costs. The figures below list the amount of labor (e.g.,

worker-days) required in each country to produce one bottle of wine or one bolt of cloth.

Wine Cloth

England 3 7

Portugal 1 5

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Since both goods are more costly to produce in England than in Portugal, England is

absolutely less efficient at producing both goods than its prospective trading partner.

Portugal has an absolute advantage in both wine and cloth. At first glance, this appears to

rule out mutual gains from trade; however, as we demonstrate below, absolute advantage

is irrelevant in discerning whether trade can benefit both countries.

The ratio of the production costs for the two goods is different in the two countries. In

England, a bottle of wine will exchange for 3/7 of a bolt of cloth because the labor

content of the wine is 3/7 of that for cloth. In Portugal, a bottle of wine will exchange for

1/5 of a bolt of cloth. Thus, wine is relatively cheaper in Portugal than in England and,

conversely, cloth is relatively cheaper in England than in Portugal. The example indicates

that Portugal has a comparative advantage in wine production and England has a

comparative advantage in cloth production.

The different relative prices provide the basis for both countries to gain from

international trade. The gains arise from both exchange and specialization.

The gains from exchange can be highlighted in the following manner. If a Portuguese

wine producer sells five bottles of wine at home, he receives one bolt of cloth. If he

trades in England, he receives more than two bolts of cloth. Hence, he can gain by

exporting his wine to England. English cloth-producers are willing to trade in Portugal;

for every 3/7 of a bolt of cloth they sell there, they get just over two bottles of wine. The

English gain from exporting cloth to land importing wine from) Portugal, and the

Portuguese gain from exporting wine to land importing cloth from) England. Each

country gains by exporting the good in which it has a comparative advantage and by

importing the good in which it has a comparative disadvantage.

Gains from specialization can he demonstrated in the following manner. Initially, each

country is producing some of both goods. Suppose that, as a result of trade, 21 units of

labor are shifted from wine to cloth production in England, while, in Portugal, 10 units of

labor are shifted from cloth to wine production. This reallocation of labor does not alter

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the total amount of labor used in the two countries; however, it causes the production

changes listed below.

Wine Cloth

England - 7 + 3

Portugal + 10 - 2

Net + 3 + 1

The shift of 21 units of labor to the English cloth industry raises cloth production by

three bolts, while reducing wine production by seven bottles. In Portugal, the shift of 10

units of labor from cloth to wine raises wine production by 10 bottles, while reducing

cloth production by two bolts. This reallocation of labor increases the total production of

both goods: wine by three bottles and cloth by one bolt. This increased output will be

shared by the two countries. Thus, the consumption of both goods and the wealth of both

countries are increased by the specialization brought about by trade based on comparative

advantage.

TRADE THEORY SINCE RICARDO

Since 1817, numerous analyses have generated insights concerning the gains from

trade. They chiefly examine the consequences of relaxing the assumptions used in the

preceding example. For example, labor was the only resource used to produce the two

goods in the example above; yet, labor is really only one of many resources used to

produce goods. The example also assumed that the costs of producing additional units of

the goods are constant. For example, in England, three units of labor are used to produce

one bottle of wine regardless of the level of wine production. In reality, unit production

costs could either increase or decrease as more is produced. A third assumption was that

the goods are produced in perfectly competitive markets. In other words, an individual

firm has no effect on the price of the good that it produces. Some industries, however, are

dominated by a small number of firms, each of which can affect the market price of the

good by altering its production decision. Some of these extensions are discussed in the

appendix.

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These theoretical developments generally have strengthened the case for an open

trading system. They suggest three sources of gains from trade. First, as the market

potentially served by firms expands from a national to a world market, there are gains

associated with declining per unit production costs. A second source of gains results from

the reduction in the monopoly power of domestic firms. Domestic firms, facing more

pressure from foreign competitors, are forced to produce the output demanded by con-

sumers at the lowest possible cost.3 Third is the gain to consumers from increased

product variety and lower prices. Generally speaking, the gains from trade result from the

increase in competitive pressures as the domestic economy becomes less insulated from

the world economy.

The gains from free trade can also be illustrated graphically. The shaded insert on pages

14 and 15 examines the gains from trade in perfectly competitive markets using supply

and demand analysis. The insert also analyzes the effects of trade restrictions, a topic that

we discuss below.

COSTS OF TRADE PROTECTIONISM

Protectionist trade policies can take numerous forms, some of which are discussed in

the shaded insert on pages 16 and 17. All forms of protection are intended to improve the

position of domestic relative to foreign producers. This can be done through policies that

increase the home market price of the foreign product, decrease the production costs of

domestic firms, or somehow restrict the access of foreign producers to the domestic

market.

The specific goal of protectionist trade policies is to expand domestic production in the

protected industries, benefiting the owners, workers and suppliers of resources to the

protected industry. The government imposing protectionist trade policies myv also

benefit, for example, in the form of tariff revenue.

The expansion of domestic production in protected industries is not costless; it requires

additional resources from other industries. Consequently, output in other domestic

industries is reduced.' These industries also might be made less competitive because of

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higher prices for imported inputs. Since protectionist trade policies frequently increase

the price of the protected good, domestic consumers are harmed. They lose in two ways.

First, their consumption of the protected good is reduced because of the associated rise in

its price. Second, they consume less of other goods, as their output declines and prices

rise.

The preceding discussion highlights the domestic winners and losers due to

protectionist trade policies. Domestic producers of the protected good and the

government (if tariffs are imposed) gain; domestic consumers and other domestic:

producers lose. Foreign interests are also affected by trade restrictions. The protection of

domestic producers will harm some foreign producers; oddly enough, other foreign

producers may benefit. For example, if quotas are placed on imports, some foreign

producers may receive higher prices for their exports to the protected market.

There have been numerous studies of the costs of protectionism. We begin by

examining three recent studies of protectionism in the United States, then proceed to

studies examining developed and, finally, developing countries.

COSTS OF PROTECTIONISM IN THE UNITED STATES

Recent studies by Tarr and Morkre (1984), Hickok (1985) and Hutbauer et al. (1986)

estimated the costs of protectionism in the United States. These studies use different

estimation procedures, examine different protectionist policies and cover different time

periods. Nonetheless, they provide consistent results.

Tarr and Morkre (1984) estimate annual costs to the U.S. economy of $12.7 billion

11983 dollars) from all tariffs and from quotas on automobiles, textiles, steel and sugar.

Their cost estimate is a net measure in which the losses of consumers are offset partially

by the gains of domestic producers and the U.S. government.

Estimates by Hickok (1985) indicate that trade restrictions on only three goods -

clothing, sugar, and automobiles - caused increased consumer expenditures of $14 billion

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in 1984. Hickok also shows that low income families are affected more than high-income

families. The import restraints on clothing, sugar and automobiles are calculated to to

equivalent to a 23 percent income tax surcharge (that is, an additional tax added to the

normal income taxi for families with incomes less than $10,000 in 1984 and a 3 percent

income tax surcharge for families with incomes exceeding $60,000.

Hufbauer et al. (19861 examined 31 cases in which trade volumes exceeded $l00

million and the United States imposed protectionist trade restrictions.4 They generated

estimates of the welfare consequences for each major group affected (see table 11. The

figures in the table indicate that annual consumer losses exceed $100 million in all but six

of the cases. The largest losses, $27 billion per year, come from protecting the textiles

and apparel industry. There also are large consumer losses associated with protection in

carbon steel I$6.8 billion), automobiles ($5.8 billion) and dairy products ($5.5 billion).

The purpose of protectionism is to protect jobs in specific industries. A useful approach

to gain some perspective on consumer losses is to express these losses on a per-job-saved

basis. In 18 of the 31 cases, the cost per-job-saved is $100,000 or more per year; the

consumer losses per-job-saved in benzenoid chemicals, carbon steel (two separate

periods), specialty steel, and bolts, nuts and screws exceeded $500,000 per year.

Table 1 also reveals that domestic producers were the primary beneficiaries of

protectionist policies; however, there are some noteworthy cases where foreign producers

realized relatively large gains. For the U.S.-Japanese voluntary export agreement in

automobiles, foreign producers gained 38 percent of what domestic consumers lost, while

a similar computation for the latest phase of protection for carbon steel was 29 percent.

Finally, table 1 indicates that the efficiency losses are small in comparison to the total

losses borne by consumers. These efficiency losses, which are defined precisely and

illustrated in the first shaded insert, result from the excess domestic production and the

reduction in consumption caused by protectionist trade policies. In large cases such as

textiles and apparel, petroleum, dairy products and the maritime industries, these losses

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equal or exceed $1 billion. It is likely that these estimates understate the actual costs

because they do not capture the secondary effects that occur as production and

consumption changes in one industry affect other industries.5 In addition, restrictive trade

policies generate additional costs because of bureaucratic enforcement costs and efforts

by the private sector to influence these policies for their own gain as well as simply

comply with administrative regulations.

COSTS OF PROTECTIONISM THROUGHOUT THE WORLD

In 1982, the Organization for Economic Cooperation and Development (OECD) began

a project to analyze the costs and benefits of protectionist policies in manufacturing in

OECD countries. The OECD (1985) highlighted a number of ways that protectionist

policies have generated costs far in excess of benefits. Since protectionist policies

increase prices, the report concludes that the attainment of sustained non-inflationary

growth is hindered by such price-increasing effects. Moreover, economic growth is po-

tentially reduced if the uncertainty created by varying trade policies depresses

investment.

Wood and Mudd (1978), and many others, have shown that imports do not cause higher

Unemployment. Conversely, the OECD study stresses the fact that a reduction in imports

via trade restrictions (toes not cause greater employment. A reduction in the value of

imports results in a similar reduction in the value of exports. One rationale for this

finding is that a reduction in the purchases of foreign goods reduces foreign incomes and,

in turn, causes reduced foreign purchases of domestic goods.

While the reduction in imports increases employment in industries that produce

products similar to the previously imported goods, the reduction in exports decreases

employment in the export industries. In other words, while some jobs are saved, others

are lost; however, this economic reality may not be obvious to businessmen, labor union

leaders, politicians and others. Luttrell (1978) has stressed that the jobs saved by

protectionist legislation are more readily observed than the jobs lost due to protectionist

legislation. In other words, the jobs that are protected in, say, the textiles industry by U.S.

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import restrictions on foreign textiles are more readily apparent (and publicized) than the

jobs in agriculture and high technology industries that do not materialize because of the

import restrictions. These employment effects will net to approximately zero.6

The OECD study also stresses that developing countries need exports to offset their

debts. Thus, protectionist trade policies by developed countries affect not only the

economic activity of the developing countries, but the stability of the international

financial system as debtor nations find it increasingly difficult to service their debts.

Not only does a free trade policy by developed countries benefit developing countries,

but a free trade policy by developing countries benefits developing countries. A recent

World Bank study (1987) of 41 developing countries compared the performance of

countries following a free trade policy with countries following a restricted trade policy.7

Table 2 lists the annual average growth in real per capita gross national product for each

of the 41 countries for 1963-73 and 1973-85. Those countries that did not bias industrial

production toward the domestic market by trade restrictions grew at faster rates than

those that did. For example, the average annual growth rate in real per capita income for

1963-73 was 6.9 percent in the economies strongly oriented to free trade and 1.6 percent

in the economies strongly oriented to restricted trade. For 1973-85 these growth rates

were 5.9 percent and - 0.1 percent, respectively.

The study proceeds to identify the macroeconomic reason for the general finding. A

given amount of new investment generated more additional output in countries following

a free trade policy than a restricted trade policy. The reason is that a free trade

environment allows capital to flow to its most highly valued uses, while a restricted trade

environment distorts economic incentives.

ARGUMENTS FOR RESTRICTING TRADE

If protectionism is so costly, why is protectionism so pervasive? This section reviews

the major arguments for restricting trade and provides explanations for the existence of

protectionist trade policies.

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NATIONAL DEFENSE

The national defense argument says that import barriers are necessary to ensure the

capacity to produce crucial goods in a national emergency. While this argument is

especially appealing for weapons during a war, there will likely be demands from other

industries that deem themselves essential. For example, the footwear industry will

demand protection because military personnel need combat boots.8

The national defense argument ignores the possibility of purchases from friendly

countries during the emergency. The possibilities of storage and depletion raise additional

doubts about the general applicability of the argument. If crucial goods can be stored, for

example, the least costly way to prepare for an emergency might be to buy the goods

from foreigners at the low world price before an emergency and store them. If the crucial

goods are depletable mineral resources, such as oil, then the restriction of oil imports

before an emergency will cause a more rapid depletion of domestic reserves. Once again,

stockpiling might be a far less costly alternative.

INCOME REDISTRIBUTION

Since protectionist trade policies affect the distribution of income, a trade restriction

might be defended on the grounds that it favors some disadvantaged group. It is unlikely,

however, that trade policy is the best tool for dealing with the perceived evils of income

inequality, because of its bluntness and adverse effects on the efficient allocation of

resources. Attempting to equalize incomes directly by tax and transfer payments is likely

less costly than using trade policy. In addition, as Hickok's (1985) study indicates, trade

restrictions on many items increase rather than decrease income inequality.

OPTIMUM TARIFF ARGUMENT

The optimum tariff argument applies to situations in which a country has the economic

power to alter world prices. This power exists because the country (or a group of

countries acting in consort like the Organization of Petroleum Exporting Countries) is

such a large producer or consumer of a good that a change in its production or

consumption patterns influences world prices. For example, by imposing a tariff, the

country can make foreign goods cheaper. Since a tariff reduces the demand for foreign

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goods, if the tariff-imposing country has some market power, the world price for the good

will fall.9 The tariff-imposing country will gain because the price per unit of its imports

will have decreased.

There are a number of obstacles that preclude the widespread application of this

argument. Few countries possess the necessary market power and, when they do, only a

small number of goods is covered. Secondly, in a world of shifting supply and demand,

calculating the optimum tariff and adjusting the rate to changing situations is difficult.

Finally, the possibility of foreign retaliation to an act of economic warfare is likely. Such

retaliation could leave both countries worse off than they would have been in a free trade

environment.

BALANCING THE BALANCE OF TRADE

Many countries enact protectionist trade policies in the hope of eliminating a balance of

trade deficit or increasing a balance of trade surplus. The desire to increase a balance of

trade surplus follows from the mercantilist view that larger trade surpluses are beneficial

from a national perspective.

This argument is suspect on a number of grounds. First, there is nothing inherently

undesirable about a trade deficit or desirable about a surplus.10 For example, faster

economic growth in the United States than in the rest of the world would tend to cause a

trade deficit. In this case, the trade deficit is a sign of a healthy economy. Second,

protectionist policies that reduce imports will cause exports to decrease by a comparable

amount. Hence, an attempt to increase exports permanently relative to imports will fail. It

is doubtful that the trade deficit will be reduced even temporarily because import

quantities do not decline quickly in response to the higher import prices and the revenues

of foreign producers might rise.

PROTECTION OF JOBS - PUBLIC CHOICE

The protection of jobs argument is closely related to the balance of trade argument.

Since a reduction in imports via trade restrictions will result in a similar reduction in

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exports, the overall employment effects, as found in the OECD (1985) study and many

others, are negligible. While the overall effects are negligible, workers (and resource

owners) in specific industries are affected differently.

A domestic industry faced with increased imports from its foreign competition is under

pressure to reduce production and lower costs. Productive resources must move from this

industry to other domestic industries. Workers must change jobs and, in some cases,

relocate to other cities. Since this change is forced upon these workers, these workers

bear real costs that they are likely to resist. A similar statement can be made about the

owners of capital in the affected industry.

Workers and other resource owners will likely resist these changes by lobbying for

trade restrictions. The previously cited studies on the costs of protectionism demonstrated

that trade restrictions entail substantial real costs as well. These costs likely exceed the

adjustment costs because the adjustment costs are one-time costs, while the costs of

protectionism continue as long as trade restrictions are maintained.

An obvious question is why politicians supply the protectionist legislation demanded by

workers and other resource owners. A branch of economics called public choice, which

focuses on the interplay between individual preferences and political outcomes, provides

an answer. The public choice literature views the politician as an individual who offers

voters a bundle of governmentally supplied goods in order to win elections.11 Many argue

that politicians gain by providing protectionist legislation. Even though the national

economic costs exceed the benefits, the politician faces different costs and benefits.

Those harmed by a protectionist trade policy for a domestic industry, especially

household consumers, will incur a small individual cost that is difficult to identity. For

example, a consumer is unlikely to ponder how much extra a shirt costs because of

protectionist legislation for the textiles and apparel industry.

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Even though the aggregate effect is large, the harm to each consumer may be small.

This small cost, of which an individual may not even be aware, and the costs of

organizing consumers deter the formation of a lobby against the legislation. On the other

hand, workers and other resource owners are very concerned about protectionist

legislation for their industry. Their benefits tend to be large individually and easy to

identify. Their voting and campaign contributions assist politicians who support their

positions and penalize those who do not. Thus, politicians are likely to respond to their

demands for protectionist legislation.12

INFANT INDUSTRIES

The preceding argument is couched in terms of protecting a domestic industry. A

slightly different argument, the so-called infant industry case, is couched in terms of

promoting a domestic industry. Suppose an industry, already established in other

countries, is being established in a specific country. The country might not be able to

realize its comparative advantage in this industry because of the existing cost and other

advantages of foreign firms. Initially, owners of the fledging firm must be willing to

suffer losses until the firm develops its market and lowers its production costs to the level

of its foreign rivals. In order to assist this entrant, tariff protection can be used to shield

the firm from some foreign competition.

After this temporary period of protection, free trade should be restored; however, the

removal of tariff protection frequently is resisted. As the industry develops, its political

power to thwart opposing legislation also increases.

Another problem with the infant industry argument is that a tariff is not the best way to

intervene. A production subsidy is superior to a tariff if the goal is to expand production.

A subsidy will do this directly, while a tariff has the undesirable side effect of reducing

consumption.

In many cases, intervention might not be appropriate at all. If the infant industry is a

good candidate for being competitive internationally, borrowing from the private capital

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markets can finance the expansion. Investors are willing to absorb losses temporarily if

the prospects for future profits are sufficiently good.

SPILLOVER EFFECTS

The justification for protecting an industry, infant or otherwise, frequently entails a

suggestion that the industry generates spillover benefits for other industries or individuals

for which the industry is not compensated. Despite patent laws, one common suggestion

is that certain industries are not fully compensated for their research and development

expenditures. This argument is frequently directed toward technologically progressive

industries where some firms can capture the results of other firms' research and

development simply by dismantling a product to see how it works.

The application of this argument, however, engenders a number of problems. Spillovers

of knowledge are difficult to measure. Since spillovers are not market transactions, thev

do not leave an obvious trail to identify their beneficiaries. The lack of market transac-

tions also complicates an assessment of the value of these spillovers. To determine the

appropriate subsidy, one must be able to place a dollar value on the spillovers generated

by a given research and development expenditure. Actually, the calculation requires

much more than the already difficult task of reconstructing the past. It requires complex

estimates of the spillovers' future worth as well. Since resources are moved from other

industries to the targeted industry, the government must understand the functioning of the

entire economy.

Finally, there are political problems. An aggressive application of this argument might

lead to retaliation and a mutually destructive trade war. In addition, as interest groups

compete for the governmental assistance, there is no guarantee that the right groups will

be assisted or that they will use the assistance efficiently.

STRATEGIC TRADE POLICY

Recent theoretical developments have identified cases in which so-called strategic trade

policy is superior to free trade. AB we discussed earlier, decreasing unit production costs

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and market structures that contain monopoly elements are common in industries involved

in international trade. Market imperfections immediately suggest the potential benefits of

governmental intervention. In the strategic trade policy argument, government policy can

alter the terms of competition to favor domestic over foreign firms and shift the excess

returns in monopolistic markets from foreign to domestic firms.

Krugman (1987) illustrates an example of the argument. Assume that there is only one

firm in the United States, Boeing, and one multinational firm in Europe, Airbus, capable

of producing a 150-seat passenger aircraft. Assume also that the aircraft is produced only

for export, so that the returns to the firm can be identified with the national interest. This

export market is profitable for either firm if it is the only producer; however, it is

unprofitable for both firms to produce the plane. Finally, assume the following payoffs

are associated with the four combinations of production: 1) if both Boeing and Airbus

produce the aircraft, each firm loses $5 million; 2) if neither Boeing nor Airbus produces

the aircraft, profits are zero; 3) if Boeing produces the aircraft and Airbus does not,

Boeing profits by $100 million and Airbus has zero profits; and 4) if Airbus produces the

aircraft and Boeing does not, Airbus profits by $100 million and Boeing has zero profits.

Which firm(s) will produce the aircraft? The example does not yield a unique outcome.

A unique outcome can be generated if one firm, say Boeing, has a head start and begins

production before Airbus. In this case, Boeing will reap profits of $100 million and will

have deterred Airbus from entering the market because Airbus will lose $5 million if it

enters after Boeing.

Strategic trade policy, however, suggests that judicious governmental intervention can

alter the outcome. If the European governments agree to subsidize Airbus' production

with $10 million no matter what Boeing does, then Airbus will produce the plane. Pro-

duction by Airbus will yield more profits than not producing, no matter what Boeing

does. At the same time, Boeing will be deterred from producing because it would lose

money. Thus, Airbus will capture the entire market and reap profits of $110 million, $100

million of which can be viewed as a transfer of profits from the United States.

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The criticisms of a strategic trade policy are similar to the criticisms against protecting

a technologically progressive industry that generates spillover benefits.13 There are major

informational problems in applying a strategic trade policy. The government must

estimate the potential payoff of each course of action. Economic knowledge about the

behavior of industries that have monopoly elements is limited. Firms may behave

competitively or cooperatively and may compete by setting prices or output. The

behavior of rival governments also must be anticipated. Foreign retaliation must be

viewed as likely where substantial profits are at stake. In addition, many interest groups

will compete for the governmental assistance. Though only a small number of sectors can

be considered potentially strategic, many industries will make a case for assistance.

RECIPROCITY AND THE "LEVEL PLAYING FIELD"

Bhagwati and Irwin (1987) note that U.S. trade policy discussions in recent years have

frequently stressed the importance of "fair trade." The concept of fair trade, which is

technically referred to as reciprocity, means different things to different people.

Under the General Agreement on Tariffs and Trade, negotiations to reduce trade

barriers focus upon matching concessions. This form of reciprocity, known as

first-difference reciprocity, attempts to reduce trade barriers by requiring a country to

provide a tariff reduction of value comparable to one provided by the other country. In

this case, reciprocity is defined in terms of matching changes.

Recent U.S. demands, exemplified by the Gephardt amendment to the current trade

legislation, reveal an approach that is called full reciprocity. This approach seeks

reciprocity in terms of the level of protection bilaterally and over a specific range of

goods. Reciprocity requires equal access and this access can be determined by bilateral

trade balances. A trade deficit with a trading partner is claimed to be prima facie evidence

of unequal access. Examples abound. For example, U.S. construction firms have not had

a major contract in Japan since 1965, while Japanese construction firms did $1.8 billion

worth of business in the United States in 1985 alone. Recent legislation bars Japanese

participation in U.S. Public works projects until the Japanese offer reciprocal privileges.

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As the name suggests, the fundamental argument for fair trade is one of equity.

Domestic producers in a free trade country argue that foreign trade barriers are unfair

because it places them at a competitive disadvantage. In an extreme version, it is asserted

that this unfair competition will virtually eliminate U.S. manufacturing, leaving only jobs

that consist primarily of flipping hamburgers at fast food restaurants or, as Bhagwati and

Irwin have said, rolling rice cakes at Japanese-owned sushi bars. While domestic

producers are relatively disadvantaged, the wisdom of a protectionist response is

doubtful. Again, the costs of protectionism exceed substantially the benefits from a

national perspective.

In an attempt to reinforce the argument for fair trade, proponents also argue that

retaliatory threats, combined with changes in tariffs and non-tariff barriers, allow for the

simultaneous protection of domestic industries against unequal competition and induce

more open foreign markets. This more flexible approach is viewed as superior to a

"one-sided" free trade policy. The suggestion that a fair trade policy produces a trading

environment with fewer trade restrictions allows proponents to assert that such a policy

serves to promote both equity and efficiency. In other words, not only will domestic and

foreign producers in the same industry be treated equally, but the gains associated with a

freer trading environment will be realized.

On the other hand, critics of a fair trade policy argue that such a policy is simply

disguised protectionism - it simply achieves the goals of specific interest groups at the

expense of the nation at large. In many cases, fair traders focus on a specific practice that

can be portrayed as protectionist while ignoring the entire package of policies that are

affecting a nation's competitive position. In these cases, the foreign country is more likely

either not to respond or retaliate by increasing rather than reducing their trade barriers. In

the latter case, the escalation of trade barriers causes losses for both nations, which is

exactly opposite to the alleged effects of an activist fair trade policy.

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Critics of fair trade proposals are especially bothered by the use of bilateral trade

deficits as evidence of unfair trade. In a world of many trading countries, the trade

between two countries need not be balanced for the trade of each to be in global balance.

Differing demands and productive capabilities across countries will cause a specific

country to have trade deficits with some countries and surpluses with other countries.

These bilateral imbalances are a normal result of countries trading on the basis of

comparative advantage.14 Thus, the focus on the bilateral trade deficit can produce

inappropriate conclusions about fairness and, more importantly, policies attempting to

eliminate bilateral trade deficits are likely to be very costly because they eliminate the

gains from a multilateral trading system.

CONCLUSION

The proliferation of protectionist trade policies in recent years provides an impetus to

reconsider their worth. In the world of traditional trade theory, characterized by perfect

competition, a definitive recommendation in favor of free trade can be made. The gains

from international trade result from a reallocation of productive resources toward goods

that can be produced less costly at home than abroad and the exchange of some of these

goods for goods that can be produced at less cost abroad than at home.

Recent developments in international trade theory have examined the consequences of

international trade in markets where there are market imperfections, such as monopoly

and technological spillovers. Do these imperfections justify protectionist trade policies?

The answer continues to be no. While protectionist trade policies may offset monopoly

power overseas or advantageously use domestic monopoly power, trade restrictions tend

to reduce the competition faced by domestic producers, protecting domestic producers at

the expense of domestic consumers.

The empirical evidence is clear-cut. The costs of protectionist trade policies far exceed

the benefits. The losses suffered by consumers exceed the gains reaped by domestic

producers and government. Low-income consumers are relatively more adversely af-

fected than high-income consumers. Not only are there inefficiencies associated with

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excessive domestic production and restricted consumption, but there are costs associated

with the enforcement of the protectionist legislation and attempts to influence trade

policy.

The primary reason for these costly protectionist policies relies on a public choice

argument. The desire to influence trade policy arises from the fact that trade policy

changes benefit some groups, while harming others. Consumers are harmed by

protectionist legislation; however, ignorance, small individual costs, and the high costs of

organizing consumers prevent the consumers from being an effective force. On the other

hand, workers and other resource owners in an industry are more likely to be effective

politically because of their relative ease of organizing and their individually large and

easy-to-identify benefits. Politicians interested in re-election will most likely respond to

the demands for protectionist legislation of such an interest group.

The empirical evidence also suggests that the adverse consumer effects of protectionist

trade policies are not short-lived. These policies generate lower economic growth rates

than the rates associated with free trade policies. In turn, slow growth contributes to

additional protectionist pressures.

Interest group pressures from industries experiencing difficulty and the general appeal

of a "level playing field" combine to make the reduction of trade barriers especially

difficult at the present time in the United States. Nonetheless, national interests will be

served best by such an admittedly difficult political course. In light of the current

Uruguay Round negotiations under the General Agreement on Tariffs and Trade, as well

as numerous bilateral discussions, this fact is especially timely.

Cletus C. Coughlin is a senior economist at the Federal Reserve Bank of SL Louis. K. Alec Chrystal is

the National Westminster Bank Professor of Personal Finance at City University, London. Geoffrey E.

Wood is a professor of economics at City University, London. This article was written while Chrystal was a

professor of economics at the University of Sheffield, Sheffield, England. Thomas A. Pollmann provided

research assistance.

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APPENDIX

Developments in International Trade Theoryand the Gains from Trade

Since 1817, numerous developments have taken place in international trade theory. Theconsequences of more than one factor of production, increasing and decreasing unitproduction costs, and imperfectly competitive markets are examined in this appendix.Special attention is focused on developments in international trade theory in the lastdecade.

Increasing the Number of Factors of ProductionAssume that, in the United States, two resources, labor and capital (e.g., machines), are

used in the production of two goods, automobiles and airplanes. The prices of theseresources will be affected differently by trade. As trade develops, demand for theexported good (that is, the good in which the United States has a comparative advantage)will increase and demand for U.S. production of the imported good will fall. This demandshift causes the price of the exported good to rise relative to the price of the importedgood. Similarly, the shift ay also produce changes in the prices of resources; however,these price changes are not always obvious.

Initially, assume that the resources cannot be transferred across industries. Forexample, the labor and capital used to produce automobiles, the good imported into theUnited States, cannot be used to produce airplanes, the exported good. Consequently, asthe price of airplanes rises in the United States, the compensation for labor and capital inthe airplane industry will rise; meanwhile, the decline in automobile prices causes adecline in compensation for labor and capital in the industry. It would not be surprising iflabor and owners of capital in the industry would resist such changes by asking for tradeprotection.

While resources may not be easily transferred across industries in the short run,workers can change jobs and capital can be moved as time passes. If resources aremobile, then the longer-run consequences for labor and owners of capital are differentfrom those described above. Even if labor and capital are perfectly mobile, however, oneset of resource owners may benefit while another group is harmed by trade.1

The real world is more complicated than this discussion has allowed. There are morethan two factors of production and varying degrees of mobility for these factors. Forexample, the U.S. labor force contains scientists and engineers as well as short-ordercooks. Nonetheless, the underlying analysis does suggest some generalizations. When

1 Who wins and who loses? It depends on the U.S. endowment of capital to labor relative to other countries. If the United States has relativelylarger amounts of capital to labor relative to other countries, then owners of capital would benefit, while labor would be harmed. This result followsfrom the Stolper-Samuelson Theorem (Stolper and Samuelson, 1941). In the example, the United States is defined to be capital-abundant. Theexample also implicitly assumes that airplanes are produced by capital-intensive methods and automobiles by labor-intensive methods. Thus, theproduction of airplanes requires the use of more capital relative to labor than automobiles. Since the United States is relatively well-endowed withcapital and the production of airplanes is capital intensive, the United States will have a comparative advantage in the production of airplanes. Withthe elimination of trade barriers, the relative price of airplanes to automobiles will increase. The Stolper-Samuelson Theorem shows that anincrease in the relative price of the capital intensive good will increase the return to capital relative to the prices of both goods and reduce thereturn to labor relative to the prices of both goods.

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trade occurs, owners of the resources that are more specialized in the production ofexport goods will tend to become wealthier; those who own resources more specialized inthe production of import-competing goods will tend to lose wealth. People also gain orlose, however, depending on what happens to the prices of the goods they buy.Individuals who chiefly consume imported goods will benefit, while those who preferconsuming the exported goods will lose. Thus, the net effect on any individual dependson both the gains or losses associated with the price changes on the goods that heconsumes and the effect of trade on his wealth (or income).

Increasing Unit Production CostsA second assumption underlying the Ricardian example of the gains from trade is that

unit production costs are constant. If unit production costs rise as more is produced,however, the general conclusions about the gains from trade remain essentially un-changed. The major difference is that rising unit production costs limit the extent towhich specialization occurs.

Decreasing Unit Production Costs and Imperfect CompetitionOn the other hand, if unit production costs decrease as production increases, the extent

to which actual trade patterns can be explained by comparative advantage becomesunclear. It also forces trade theory to deal with numerous characteristics of internationaltrade in the real world. The market structure of industries engaged in trade is frequentlyhighly concentrated. In other words, the individual firms in an industry, contrary to thosein a perfectly competitive industry, can affect the market price of their good by theirproduction and advertising decisions. In addition, trade statistics show that intra-industrytrade (i.e., the simultaneous export and import of the output of the same industry)accounts for increasingly larger shares of world trade.

In the last decade, trade theorists have developed numerous models to deal with thesefacts. An exhaustive review of this rapidly expanding literature is beyond the scope ofthis appendix; however, a few illustrative articles are discussed in order to establish somekey points. Brander (1981) and Brander and Krugman (1983) developed models using ahomogeneous good to highlight how imperfect competition can cause intra-industry tradeand how intra-industry trade can arise in the absence of cost differences.

Assume two countries with one firm in each country. The firms are producing ahomogeneous good under identical cost situations and there are no transportation costs.Each firm operates under what is termed a "Cournot conjecture," meaning that each firmassumes its production decision will not affect its rival's production decision. Beforeinternational trade, each firm has a monopoly position in its home market. Allowing forfree trade induces each firm to enter the other firm's market, because price exceedsmarginal cost in each country. Thus, the same good will flow to and from each country.

Kierzkowski (1987) has noted that the bulk of intra-industry trade involvesdifferentiated rather than homogeneous goods. Two approaches, Lancaster's (1979)characteristics approach and Dixit and Stiglitz's (1977) "love of variety" approach, haveprovided the foundation for trade models involving differentiated goods.

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In the characteristics approach, individuals have preferences for the characteristics ofgoods rather than for collections of the goods themselves. A group of goods is defined asgoods possessing the same characteristics but in different proportions. A diversity inconsumer preferences causes different consumers to prefer different products (i.e.,varieties) of a group of goods.

Helpman (19811 and Lancaster (1980) used the characteristics approach to show howintra-industry trade results from combining the demand for variety with economies ofscale. The change from autarchy to free trade enlarges the market and causes output ofthe existing varieties to increase and the production of new varieties to begin. Consumersgain from the production of more varieties and lower prices as economies of scale arerealized.

The sources of gains from trade are identical using the love-of-variety andcharacteristics approaches. In the love-of-variety approach, which is used by Dixit andNorman (1980), consumers have identical tastes and prefer to consume as many types ofthe differentiated product as possible.

The introduction of imperfect competition and declining unit production costs suggestthree sources of gain from free trade. As the market potentially served by firms expandsfrom a national to a world market, there will be gains due to declining unit productioncosts. The second is the reduction in monopoly power of firms faced with foreigncompetitors. The third is the gain to consumers from lower prices and increased productvariety. Generally speaking, gains from trade result from the increase in competitivepressures as the domestic economy becomes less insulated from the world economy.Nonetheless, the numerous market structures and firm behaviors possible under imperfectcompetition preclude a definitive statement about the optimality of free trade.

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Bhagwati, Jagdish N., and Douglas A. Irwin. "The Return of the Reciprocitarians - U.S. Trade PolicyToday," World Economy (June 1987), pp. 109-30.

Brander, James A. "Intra-Industry Trade in Identical Commodities," Journal of International Economics(February 1981), pp. 1-14.

Brander, James A., and Paul R. Krugman. "A 'Reciprocal Dumping' Model of International Trade," Journalof International Economics (November 1983), pp. 313-21.

Chrystal, K. Alec, and Geoffrey E. Wood. "Are Trade Deficits a Problem?" this Review (January/February1988), pp. 5-13.

Clarete, Ramon L., and John Whalley. "Interactions Between Trade Policies and Domestic Distortions,"Center for the Study of International Economic Relations Working Paper 8522C (London, Ontario:University of Western Ontario, 1985).

Coughlin, Cletus C. "Domestic Content Legislation: House Voting and the Economic Theory ofRegulation," Economic Inquiry (July 1985), pp. 437-48.

Denzau, Arthur T. "How Import Restraints Reduce Employment," Washington University Center for theStudy of American Business, Formal Publication #80 (June 1987).

Destler, I. M., and John S. Odell. Anti-Protection: Changing Forces in United States Trade Politics(Institute for International Economics, 1987).

Dixit, Avinash K., and Victor D. Norman. Theory of International Trade (Cambridge University Press,1980).

Dixit, Avinash K., and Joseph E. Stiglitz. "Monopolistic Competition and Optimum Product Diversity,"American Economic Review (June 1977), pp. 297-308.

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Grais, Wafik, Jaime de Melo, and Shujiro Urata. "A General Equilibrium Estimation of the Effects ofReductions in Tariffs and Quantitative Restrictions in Turkey in 1978," in T. N. Srinivasan and JohnWhalley, eds. General Equilibrium Trade Policy Modeling (MIT Press, 1986).

Grossman, Gene M. "Strategic Export Promotion: A Critique," Strategic Trade Policy and the NewInternational Economics in Paul R. Krugman, ed. (MIT Press, 1986), pp. 47-68.

Helpman, Elhanan. "International Trade in the Presence of Product Differentiation, Economies of Scale andMonopolistic Competition," Journal of International Economics (August 1981), pp. 30540.

Hickok, Susan. "The Consumer Cost of U.S. Trade Restraints," Federal Reserve Bank of New YorkQuarterly Review (Summer 1985), pp. 1-12.

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Wimmer. "A Confusion of Economists?" American Economic Review, Papers and Proceedings (May1979), pp. 28-37.

Kierzkowski, Henry K. "Recent Advances in International Trade Theory: A Selective Survey," OxfordReview of Economic Policy (Spring 1987), pp. 1-19.

Krugman, Paul R. "Is Free Trade Passe?" Journal of Economic Perspectives (Fall 1987), pp. 131-44.

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Lancaster, Kelvin. "Intra-Industry Trade Under Perfect Monopolistic Competition," Journal of InternationalEconomics (May 1980), pp. 151-75.

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ENDNOTES

1 See Page (1987) for a detailed examination of trade protectionism since 1974.

2 This consensus was found in a survey published in the late 1970s (Kearl et al., 1979).Recent developments in international trade theory, which can be used to justifygovernmental intervention in trade policy, have not altered the consensus (Krugman,1987).

3 A profit-maximizing firm produces its output at minimum cost. When firms areinsulated from competition, costs are not necessarily being minimized. This situation,which is called X-efficiency, has been stressed by Leibenstein (1980). The increase incompetitive pressures due to international trade reduces the probability that costs arenot minimized.

4 While there were cases in which the industry adjusted to its new competitive positionand the protection was terminated, these cases were more the exception than the rule.In far more cases, protectionist policies were maintained indefinitely or removedbecause of favorable demand changes.

5 Recent estimates of the costs of protectionist policies using general equilibrium modelssuggest that the secondary effects, to the limited extent they are measurable, aresubstantial. For example, Grais, de Melo and Urata (1986) estimate that the eliminationof quotas in Turkey in 1978 would have caused a 5.4 percent rise in gross domesticproduct, while Clarete and Whalley (1985) estimate that the elimination of tariffs,quotas and export taxes in the Philippines in 1978 would have caused a 5.2 percentrise in gross national product.

6 Recent evidence shows that protectionist legislation actually may reduce employment.Denzau (1987) estimated that 35,600 manufacturing jobs were lost as a result of theSeptember 1984 voluntary export restraints that limited the level of U.S. steel imports.Despite an increased employment for producers of steel (14,000) and producers ofinputs for steel producers (2,800), these increases were more than offset by the 52,400job losses by steel-using firms. These losses are due to the higher steel prices thatcause steelusing firms to be less competitive in export markets and subject them tomore foreign competition in the U.S. market.

7 The World Bank study divides trade strategies into two groups: outward oriented andinward oriented. An outward-oriented strategy, which we call a free trade policy, is onein which trade and industrial policies do not discriminate between production for thedomestic market and exports, nor between purchases of domestic and foreign goods. Aninward-oriented strategy, which we call a restricted trade policy, is one in which tradeand industrial policies are biased toward production for the domestic market relative tothe export market.

8 See Pine (1984).

9 If a country such as the United States has no market power, the world price is fixed.Consequently, the price faced by U.S. consumers and producers rises by the fullamount of the tariff. In the optimum tariff case, the price faced by U.S. consumers andproducers rises, but not by the full amount of the tariff. This must be the case becausethe world price falls and the amount of the tariff is the difference between the worldprice and the U.S. price.

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10 See Chrystal and Wood (1988) earlier in this issue.

11 The role of pressure groups, acting in their economic self-interest,has been stressed by Stigler (1971) and Peltzman (1976). For references, as well as anexample of an international trade study focused on the interaction of politicians andinterest groups, see Coughlin (1985).

12 Special interests benefiting from trade will likely resist the forces for protectionistlegislation. Destler and Odell (1987) identify exporters, industrial import users, retailersof imported products, businesses providing trade-related services, foreign exporters,and foreign governments as interest groups capable of exerting some anti-protectionpressure. Decisions about protectionist legislation result from the interaction of bothpro-protection and anti-protection forces.13 A recent volume edited by Paul Krugman (1986) examines the policy implications ofthe new trade literature. See Grossman's article in that volume for a discussion of theinformation requirements.

14 Bergsten and Cline (1985) estimate an equilibrium U.S.-Japanese bilateral tradedeficit of $20-$25 billion annually.